Accounting 3 (2017) 131–136

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Accounting
homepage: www.GrowingScience.com/ac/ac.html

Price-to-earnings ratio: A state-of-art review

Mohammad Reza Ghaeli*

Adjunct Professor, School of Management, New York Institute of Technology, 1700 - 701 W Georgia St.,Vancouver, BC V7Y 1K8 Canada

CHRONICLE ABSTRACT

Article history: One of the primary tools for asset evaluation on stock market is to use price-to-earnings (P/E)
Received December 5, 2014 ratio. The method is simple and has become popular among many investors for buy/sell
Received in revised format decisions. In this paper, we present a comprehensive review on recent advances on the use of
February 16 2016
P/E ratio for measuring other firms’ characteristics. The survey has reviewed several studies
Accepted July 1 2016
Available online on the relationship between P/E ratio and stock performance, estimation of transaction data,
July 27 2016 insider transaction, future growth, firm size, interest ratio, book-to-market equity, etc.
Keywords:
Price-to-earnings
P/E ratio
Stock exchange © 2017 Growing Science Ltd. All rights reserved.

1. Introduction

The price-earnings ratio (P/E Ratio) is the ratio for assigning a value for a firm that measures its current
share price relative to its per-share earnings (Nicholson, 1960). The price-earnings ratio is normally
calculated as the market value per share divided by earnings per share. There are several methods for
calculating P/E ratios. EPS is normally extracted from the recent 4 quarters, which forms trailing P/E
ratios and it can be measured by subtracting a firm’s share value at the start of the 12-month period
from its value at the period’s end, adjusting for stock splits in case there is any. Another form of P/E
ratio is associated with analysts’ prediction of earnings anticipated during the next 4 quarters called
projected or forward P/E (Nicholson, 1960). Normally, a high P/E ratio implies that investors are
anticipating higher earnings growth within the next years while firms with a lower P/E are expected
lower growth. In fact, a low P/E indicates either a firm is presently undervalued or it is performing
exceptionally well relative to its past trends (Goodman & Peavy III, 1986). Most researchers believe
value shares will definitely outperform glamour shares in the long term but the reason on why glamour
shares remain popular stays behind the P/E ratio to discriminate between the value asset versus glamour
one (Anderson & Zastawniak, 2016). According to Deaves et al. (2008) a significant variation in the

* Corresponding author.
E-mail address: rghaeli@nyit.edu ( R Ghaeli)

© 2017 Growing Science Ltd. All rights reserved.

doi: 10.5267/j.ac.2016.7.002
132

Canadian E/P ratio can be described by a combination of the lagged level of the E/P in coordination to
variability in logical explanatory factors.
When a firm has no earnings or is reporting losses, P/E will not be available and this measure cannot
be used for asset evaluation. Theoretically, by taking the mean/median of P/E ratios over a long period
of time, we may reach to a standardized P/E ratio considered as a benchmark and learn more about
whether or not a firm can be considered as a buying opportunity (Wisniewski et al., 2012). The P/E
ratio changes from one sector to another one and, thus, when we compare two firms in two various
sectors, it is not wise to look at P/E ratios to compare two firms. An individual firm’s P/E ratio is
meaningful when considered with P/E ratios of other firms within the same sector. For instance, a firm
in energy sector normally yields a high P/E ratio, but this may reflect a trend within the sector rather
than one solely within the individual firm1. Fig. 1 demonstrates the average P/E ratio from 1871 to 2016
for Standard & Poor 500 (S&P 500).

80

70

60

50
P/E ratio

40

30

20

10

0
Jan 1, 1871
Jan 1, 1876
Jan 1, 1881
Jan 1, 1886
Jan 1, 1891
Jan 1, 1896
1‐Jan‐01
1‐Jan‐06
1‐Jan‐11
1‐Jan‐16
1‐Jan‐21
1‐Jan‐26
1‐Jan‐31
1‐Jan‐36
1‐Jan‐41
1‐Jan‐46
1‐Jan‐51
1‐Jan‐56
1‐Jan‐61
1‐Jan‐66
1‐Jan‐71
1‐Jan‐76
1‐Jan‐81
1‐Jan‐86
1‐Jan‐91
1‐Jan‐96
1‐Jan‐01
1‐Jan‐06
1‐Jan‐11
1‐Jan‐16
Year

Fig. 1. Average P/E ratio of S&P 500 from 1871 to 2016

Source: http://www.econ.yale.edu/~shiller/data.htm
As we can observe from the figure, the average P/E ratio has fluctuated year over year from 5.31 in
December, 1917 to 123.73 in May, 2009. In addition, the mean and median of the P/E ratio were 15.60
and 14.63, respectively. Another observation is that when the P/E ratio is relatively high, this does not
mean that the bull session continues for good and when it is low it also does not mean that the bear
session continuous forever (French & Poterba, 1991). There are literally different technical indicators
for detecting buy/sell on stock market including moving average, relative strength index, stochastic
oscillator, etc.
2. P/E ratio
Basu (1977) is believed to be the first who tried to detect whether or not the investment performance
of common stocks is associated with their P/E ratios. Penman (1996) made an assessment on the
relationship between the P/E ratio and the market-to-book ratio (P/B) and how both ratios was

1http://www.investopedia.com/terms/p/price-earningsratio.asp
 M R Ghaeli / Accounting 3 (2017) 133

associated with current and future earnings growth. He reported that P/Es were associated with current
return on equity but were poor indicators of future growth, and P/Bs yielded the effect of future
profitability and were good indicators of earnings growth. Cook and Rozeff (1984) investigated the
implied standard deviation (ISD) estimated from transactions data on options, based the Black-Scholes
pricing model. They reported that the distribution of the ISD was symmetric but not normal. In addition,
the ISD based on the last daily observation deviated substantially from the daily average ISD. Beaver
and Morse (1978) reported that evident persistence in P/E ratios is neither growth nor risk but
differences in accounting method. In stock market companies with low P/E ratios earn higher stock
returns in the long term than high growth firms with high P/E ratios.
Houmes and Chira (2015) studied how insider ownership could possibly influence on this relation by
describing that when insider ownership is high, returns reduce for low P/E companies and help for high
P/E firms. For low P/E companies, low stock returns represent the inability of boards of directors and
outside shareholders to affect poorly performing entrenched management. Chen et al. (2015)
investigated whether predicting future earnings can create risk-adjusted returns. We find that the risk-
adjusted returns of portfolios constructed on future E/P ratios are superior to those constructed on past
E/P ratios under the four-factor model. The risk-adjusted returns increase monotonically with the
number of future quarters used to compute the E/P ratios. Moreover, the risk-adjusted returns for the
firms with high E/P ratios are positively related to the changes between past earnings and future
earnings. Overall, forecasting future earnings precisely would significantly enhance the risk-adjusted
returns of portfolios.
Wu (2014) reported that the forward earnings per price (E/P) ratio was a stronger estimator of future
growth than the traditionally used trailing E/P ratio. Baker et al. (2013) investigated trends in farmland
values, cash rents, interest rates, the farmland price to cash rent (P/Rent) multiple, and the P/E ratio on
stocks. The P/Rent multiple averaged 17.6 over the period 1960-2012 and ranged from 11.1 in 1986 to
29.5 in 2012. Firms of the P/Rent ratio to the P/E ratio provided that the present P/Rent ratio was above
the current P/E ratio and substantially above both the long-term P/Rent and P/E ratios.
According to Chhaya and Nigam (2015) value strategies based on low price relative to earnings,
dividends, book value and other fundamental measures, could outperform the corresponding ‘growth
strategies’ and the market. They tried to study this premise in the Indian context by forming equity
portfolios based on P/E ratios and evaluated their ex post returns on both absolute and risk adjusted
measures. They reported some evidence of statistically substantially value premium in the Indian stock
market.

Arslan et al. (2014) analyzed the effect of dividend yield and P/E ratio on stock returns and determined
the relationship between size and stock price based on the data from 111 non-financial KSE listed firms
over the period 1998-2009. They reported that P/E ratio and size of firm had substantial positive effect
on stock prices. They also reported negative relationship between dividend yield and stock prices. Their
results also recommended that investors could use investment criteria that include size of firm and P/E
ratio anomalies to earn abnormal return.
Al-Mwalla et al. (2010) investigated long run relationship between stock prices, P/E, dividend yields
and size of firms and reported Jordan Stock Market faced informational lack of efficiencies and
business managers and investors started their investment by utilizing P/E and size anomalies to earn
abnormal returns. San Ong et al. (2010) investigated the ability of value investing strategy on
forecasting stock performance in terms of the fall in stock prices in Malaysia by observing the
development of the Malaysian stock market index, the Kuala Lumpur Composite Index (KLCI) and its
P/E ratio over the period 1994-2010, when there was a financial crisis of the 1997/98 Asian financial
crisis and the global financial crisis of late. The results indicated that P/E ratio could provide good
insight on the performance of KLCI.
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Lam (2002) studied the relationship between stock returns and β, size (ME), leverage, book-to-market
equity ratio, and earnings–price ratio (E/P) in Hong Kong stock market based on the Fama and French
(1992) approach. Fama and French (1992) reported that two variables, size and book-to-market equity,
combine to reach the cross-sectional variation in average stock returns related to β, size, leverage, book-
to-market equity, and E/P ratios. Lam (2002 reported that β was unable to provide the average monthly
returns on stocks continuously listed in Hong Kong Stock Exchange. However, three of the variables,
size, book-to-market equity, and E/P ratios, appeared to capture the cross-sectional variation in average
monthly returns. They also recommended that their results were not driven by extreme observations or
abnormal return behavior for some of the months or by size groups.
Lafmejani (2017) presented a survey to learn whether or not there is any difference between the returns
of two value and growth portfolios, sorted by P/E and price-to-book value (P/BV), according to the
ratios of market sensitivity to index (β), firm size and market liquidity in listed firms in Tehran Stock
Exchange (TSE) from 2001 to 2008. The selected companies were chosen from those with existing
two-consecutive positive P/E and P/BV ratios and by excluding financial and holding firms. There were
five independent variables for the proposed study of this paper including P/E, P/B, market size, market
sensitivity beta (β) and market liquidity. For each year, they first sort companies in non-decreasing
order and setup four set of portfolios with equal companies. Thus, the first portfolio with the lowest
P/E ratio was called value portfolio and the last one with the highest P/E ratio was named growth
portfolio and repeated the process based on P/BV ratio to detect value and growth portfolios,
accordingly. The study studied the characteristics of two portfolios based on firm size, β and liquidity
and their results indicated mix effects of market sensitivity, firm size and market liquidity on returns of
the firms in various periods.
Lau et al. (2002) investigated the relationship between stock returns and beta, size, the E/P ratio, the
cash flow-to-price ratio, the book-to-market equity ratio, and sales growth (SG). They reported the
existence of anomalies in these emerging markets based on the data from Singapore and Malaysia for
the period 1988–1996 and reported a conditional relationship between beta and stock returns for both
countries. During months with positive market excess returns, there was a substantial positive
relationship. They also reported a negative link between beta and stock returns when market faced with
negative signals. They documented a negative effect of stock returns on size for both countries. For
Singapore, they also reported a negative relationship between returns and SG while in Malaysia, they
reported a positive relationship between returns and the E/P ratio.
Weigand and Irons (2007) investigated the market P/E ratio and its relationship to future stock return,
aggregate earnings and interest rates in the US market. They forecasted of ten-year real stock returns
based on the level of the market earnings yield (E/P ratio or P/E ratio), and determined that their
predictions were not as bad as those made in other modes. Estrada (2005) compared the performance
of a low‐P/E strategy relative to that of two alternative value strategies, one based on the PEG ratio and
another on the PERG ratio. They reported that the ones sorted by PERG ratios could perform better
than the one based on both P/E ratios and PEG ratios.
Weske and Benuto (2015) performed an empirical investigation to determine a fraud based on the
changes in share price and P/E ratios prior to a public announcement for a sample firms selected from
US matket between 2000 and 2004. They reported a substantial relationship between firms prosecuted
for fraud and the coefficient of variation. However, the relationship between the price/earnings ratio
and firms prosecuted for fraud was insignificant.
According to Zorn et al. (2009), the P/E ratio is normally implemented as a metric to compare individual
stocks and the market as a whole relative to historical valuations. Zorn et al. (2009) investigated the
factors that influence changes in the inverse of the P/E ratio (E/P) over time in S&P 500 Index. The
proposed model included variables which measure investor beliefs and changes in tax rates and
indicated that these variables were essential factors influencing on the P/E ratio. They extended prior
work by modifying for the presence of a long-run relationship between variables included in their model
 M R Ghaeli / Accounting 3 (2017) 135

and reported that changes in the P/E ratio had some predictive power. The model also described a large
portion of the variation in E/P and accurately forecasted the future direction of E/P, specifically when
forecasted changes in E/P were large or gave a consistent signal over more than one quarter.
3. Summary
In this paper, we have discussed the merit of simple ratio on predicting market value, detecting bull/bear
session and even predicting fraud in earnings announcement. The survey has reviewed several studies
on the relationship between P/E ratio and stock performance, estimation of transaction data, insider
transaction, future growth, etc. The study has covered a wide scope of studies performed on different
stock exchanges.
Acknowledgement
The authors would like to thank the anonymous referees for constructive comments on earlier version
of this paper.
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